General Theory - General Theory

General TheoryFutures contracts are at once as new as the smart phone and as old as agriculture itself. As technologically advanced, sophisticated and globally interconnected as trading is today, humanity's collective memory can barely recall a time before some form of agreement between farmers and consumers ensured that the harvest would be distributed equitably.

Development of Futures MarketsThe futures market is based on a concept that must be, if not almost as old as farming itself, then almost as old as exchanging farm produce for currency.

To understand its origins, it is best to recall a time when people had been working on settled fields for many generations, and traders and craftsmen, having founded the first towns, were experimenting successfully with currency as a means of exchange.

Agriculture had always been a difficult way to make a living. A farmer is faced with the difficulty of producing the proper amount of a given crop at harvest. Mistakes lead to supply and demand imbalances that could disadvantage either the farmer or the consumer. The fickle nature of weather is a critical input in the planting decision.

But what if, just before planting season, a merchant promises to pay a thousand dollars for a hundred bushels of barley, with dollars and bushels both to be delivered on the day following the full moon of the harvest month? Then the farmer knows that he has to plant enough barley so that, unless the weather is truly disastrous, he will be able to glean at least 100 bushels. Any less and he has broken his promise, but any more he can sell at the harvest month's prevailing price which could very well be higher than the contracted price. At any rate, he now knows how much seed he has to buy, how much of his land he has to cultivate for barley, and how much of his own time and energy he needs to commit.

The risk is transferred to the merchant; if the merchant can't sell 100 bushels, that's not the farmer's problem any longer. But if, as the merchant's brother-in-law the soothsayer predicts, it will be an unusually dry summer, then the merchant has just locked up the first 100 bushels and can name his own price for barley at the town market.

Of course, there are other farmers and other merchants. Soon, they'd see how mutually beneficial these contracts could be and eventually these contracts would become as popular as transactions for straight currency. As that harvest moon date got closer, it would become clearer whether the farmers would be able to deliver and what prices the end consumers would be willing to pay. As a result, farmers who couldn't produce could sell their obligations to farmers who could, and get their money immediately. Merchants who believed they overbought could sell their obligations to other merchants who believed they hadn't bought enough. Eventually, there'd be a market for these contracts similar to the market for their underlying commodities.

The next innovation was the to-arrive contract, a precursor to the futures contract which was an agreement to purchase designated goods once the ship they were laden on arrived. For centuries, to-arrives were used to smooth the risks and encourage the growth of international trade.

Some of the earliest grain futures markets were founded in New York City and Buffalo, but by the 1840s, Chicago had become the city most associated with futures. As the railroad hub that connected Midwestern farmers with East Coast consumers, it was only natural that markets would become established there. Thus the seminal American futures bourse, the Board of Trade of the City of Chicago, was established in 1848. The Board provided a centralized location for both cash and contract trading. Its members (owners) were brokers who earned commissions by facilitating trades.

Up to now we have been talking about forward contracts, which are binding agreements to deliver goods in exchange for payment for those goods at a specified date. These are bespoke (customized to each trade and not bought and sold through an exchange) and agreed upon between two parties with no middlemen.

The organization that would simplify its name to the Chicago Board of Trade (CBOT), though, invented the modern futures contract. A futures trader's responsibility is limited to negotiating price and the number of contracts, so you can see how futures would be easier to trade. As a result, the members of the Chicago exchange quickly discovered that their contracts could change hands (e.g. be settled or offset) over and over again before expiration. There were profits to be made every time prices changed. There were also losses that could be incurred; savvy investors soon learned to hedge their bets by buying a contract that they had previously sold or selling a contract that they had previously bought.

Other futures exchanges were later established throughout the United States, but the most important CBOT rival opened up right down the street. The

In the case of both futures and forwards, though, the contracts could only be settled by physical delivery of commodities.

For decades, the futures markets served primarily agricultural needs. In the early 1970s, futures were created for financial products. The end of the gold standard and the resultant unshackling of currencies to the price of gold led to the creation of currency futures. Today, currency, interest rate and stock index futures are common derivatives used for hedging and speculation.

As with agricultural products, the forward market pre-dated the futures market. The CME became the first forward market for currency trading and, later in 1971, became the first futures market through its subsidiary, the International Monetary Market (IMM).

Once the currency futures market was conceived, it was just a short walk to the proposition of interest rate futures – contracts on changes in the cost of borrowing money.

That interest rate futures could exist isn't that hard to understand. Interest, after all, is as much an undifferentiated commodity as potatoes or pounds sterling. It's simply a matter of counterparties taking bets.

The need to hedge interest rates (the price of money) is not much different from that for currency futures. The goal is to secure a favorable price of a good, in an effort to safeguard it against price change. All companies have to borrow money and, thus, have to pay interest. When they enter into a variable-rate loan, they're essentially betting that interest rates will go down over the period. When they enter into a fixed-rate loan, they're betting that rates will go up. The banks they're borrowing from are, of course, taking the opposite positions. With interest rate futures, both companies and banks can hedge their bets – in effect trading a portion of their variable-rate loans for portions of someone else's fixed-rate loans, or vice versa.

Again, the CME is credited with this innovation, launching a 90-day U.S. Treasury bill futures contract in 1976. Shortly after that, the CME took elements of currency futures and interest rate futures and developed the eurodollar contract, which offers counterparties positions on interest rates paid for U.S. dollars on deposit overseas.

In very short order, interest rate futures became the most heavily traded commodities on the market. Eventually, the agricultural commodities upon which the first futures exchanges were built lagged behind all the different flavors of financial products.

Futures and forwards are the oldest forms of derivatives, so called because they derive their value from an underlying, more fundamental good. The other types of derivatives are options and swaps. Some options have futures contracts as their underlying product, which of course have underlying products of their own.

In the early 1980s, the next wrinkle in the development of financial futures markets turned out to be the development of stock index futures. Changes in index values have serious repercussions on mutual funds and pension funds, so there was a ready-made pool of market participants who might want to establish a position that the market was going up, and others who believed it was heading down. Of course nobody knows for sure what the stock market is going to do, and almost everyone who plays in it to the degree the big funds do, would want to hedge whatever bets they made. The beauty of index futures is that they enable these funds to place bullish or bearish bets without having to buy any actual shares in the underlying companies. CME launched its first stock index futures contract, the S&P 500 contract, in 1982. Such futures helped the user lower its cost of hedging and speculation.

The New York Board of Trade (NYBOT) has been particularly innovative with indices. While the exchange does trade in stock market indicators, its U.S. Dollar Index allows investors to take a position in the strength of the U.S. dollar without reference to any other specific currency, and its two commodities indices allows investors to take a position in the entire market basket without reference to any specific underlying product.

Meanwhile, the CME has created such alternative markets as weather futures and housing futures.